Options in the Volatile Environment

The more uncertain a trading environment, the greater your concern for the safety of your capital. When prices are very low, you may be fearful about placing capital at risk, especially if you have already lost money in the market. At the same time, such moments are buying opportunities.

If you have cash to invest but you are concerned about market volatility, limited speculation could be a wise strategy.

While buying calls is highly speculative due to the unavoidable expiration factor, the decision can work as an alternative strategy. Instead of putting all of your capital at risk in purchasing shares, you can buy calls as a method for controlling stock. If and when those shares climb in value, the calls can be exercised and you can purchase shares at the fixed striking price. But if stock prices decline, you are not obligated to exercise and you will lose only the money invested in call premium.

Considering that time works against the buyer, is it wise to buy calls as an alternative to simply buying stock? It can be. Using long-term equity anticipation security (LEAPS) calls with long-term life spans can make a lot of sense in volatile markets. Because LEAPS options last up to 36 months, they are more interesting than shorter-term listed options. In the market, 36 months is a very long time. If you select stocks that you believe have a better than average chance to appreciate in value, going long on LEAPS calls could be a profitable form of speculation.

When you buy long-term LEAPS calls, you will have to expect to pay extra premium for more time value. So LEAPS calls are going to be far more expensive than shorter-term calls; but with the time element in mind, the longer-term speculation can work to your advantage. There are ways to reduce the cost of long-term LEAPS positions as well. Advanced strategies employing LEAPS calls are explained in detail Combined Techniques: Creative Risk Management. For example, you can purchase a call and then sell earlier-expiring calls with higher striking prices. This strategy reduces the cost of the long call. It is a relatively safe strategy, because the long position covers the short. Because you will have up to 36 months before the long LEAPS call expires, you can sell a series of short calls and allow them to expire during the holding period.

Another possible strategy for those who already own shares and want to acquire more is to sell a covered call and an uncovered put at the same time. Using LEAPS options, this can create a substantial rate of return. So there are numerous LEAPS strategies, both long and short, that provide you with alternatives to the popular stock-specific strategies: dollar cost averaging, hold-and-wait strategies, profit taking, or simply getting out of the market. The use of options, especially longer-term LEAPS options, allows you to remain in the market and to create new opportunities with minimum risk.

Smart Investor Tip

LEAPS-based strategies can be tailored to match your risk tolerance. The big advantage with LEAPS is the extended time until expiration.

The problem of investing more capital in a down market is well known. Typically, when prices are down, there are numerous buying opportunities available; but it is also common for people to hesitate, fearing further declines. In this condition, it requires a cool head and calm nerves to go against the crowd mentality of the market, and to recognize the opportunity. Using LEAPS options, you can take advantage of depressed prices, without risking capital in long positions.

Example

Solving the Capital Problem: You have approximately $10,000 to invest. You have been following five stocks that you believe will increase in value over the next two to three years; but you cannot buy 100 shares of all of these with your limited capital. And because the market has been very volatile lately, you are not even sure that the timing is right for committing money right now. You don't want to miss an opportunity, and you remain uncertain about short-term volatility.

In the circumstances just described, there are three problems: (1) limited capital, (2) uncertainty about short-term price volatility, and (3) the desire to profit from longer-term change. Everyone faces these conditions from time to time, and many face them continually. LEAPS options address all three concerns. With a $10,000 capital base as described, it is possible to buy calls for all five of the stocks. As long as options are picked out of the money, the premium cost will be lower than it would be for an in-the-money option on the same 100 shares. This diversifies the $10,000 capital into five different 100-share lots; but because these are options and not shares, the risk of loss is limited. The entire $10,000 could be lost if none of the stocks rises in value. But if they are selected well, that is a remote possibility at best. Three years is a very long time and in the cyclical market, today's depressed conditions are likely to reverse and price will advance.

Smart Investor Tip

The LEAPS option removes the most inhibiting factor of the options market, the short-term nature of contracts and ever-looming expiration. A three-year life span is an eternity in the stock market.

Is it prudent to buy calls, given the risks of long positions as a general rule? It could make more sense than buying shorter-expiring standardized calls, which will expire in a few months. Remembers, a LEAPS contract has a life up to three years, and a lot can happen in that time. If you believe that stocks will rise in value during those months, then buying long-term options represents a smart strategic choice. If the market value does not rise, you lose the option premium. However, since you will be spreading a limited amount of capital among options on several different stocks, you stand a good chance of profiting overall as long as the market direction is upward during the lifetime of the LEAPS.

There are three possible outcomes in this strategy:

The LEAPS expires worthless. If the stock fails to rise above the LEAPS striking price, the strategy produces a loss.

The LEAPS increases in value and you close it at a profit. You might decide later on that you would rather take the option profit when available, and give up the opportunity to buy shares later.

The stock value rises and you exercise the LEAPS option, purchasing shares at the fixed striking price. This is the strategy to aim for; LEAPS are used to own the right to buy 100 shares at a fixed price, with the idea that you will want to make the purchase as long as fundamental conditions do not change.

LEAPS can be used in all of the ways that short-term options can be used. LEAPS calls can be bought to insure against losses in short stock positions; and LEAPS puts can be used to insure against losses in long stock positions. You can also sell LEAPS, either naked or covered. The covered call strategy will produce far higher premium income because of higher time value. In exchange, you will also be required to keep your stock tied up to cover the short option for a longer period of time. The typical time value pattern for LEAPS is that it remains fairly stable and then rapidly falls off during the last four to six months. Thus, covered call writing on very long-term periods should be analyzed and compared with shorter-term alternatives. When comparing likely rates of return, remember to annualize the outcomes to make them comparable; a 10 percent return on a one-year covered call is twice as profitable as a 15 percent return on a three-year covered call.

Smart Investor Tip

The risk/reward question for LEAPS covered call writers has to be analyzed carefully. The question of time is one aspect only, and the other aspectâexposure to exerciseâis much longer term than for standard short-term options.

The potential uses of LEAPS beyond expected purchase (or sale) of shares in the future can become quite interesting. When you combine the longer expiration of LEAPS options with the features of shorter-term expirations, some of the typical trading techniques become more advantageous, especially on the short side. Remember, time works for the seller and against the buyer. As a seller of a LEAPS option, you are going to have more time value to work with and a longer time until expiration. As a buyer of a LEAPS option, you still work against time; but because expiration is so far away, the potential for profitâor at least the uncertainty of what will happenâmakes buying options far more feasible.

The advantage of an extended time until expiration is partially offset by the LEAPS tendencies with extrinsic value, seen in variation in the LEAPS delta. When options are close to expiration, they tend to be very responsive to changes in the stock's price. However, the farther out the LEAPS, the less responsive it is likely to be.

This reality often means the LEAPS premium changes very little even when the stock price moves many points. For example, if you own a LEAPS call and the underlying stock moves up three points, you might see only one point (or no points) of movement in a 24-month LEAPS call. What actually occurs in this situation is that extrinsic value falls as an offset against intrinsic value (assuming the call is in the money), or, if out of the money, the extrinsic value fails to react to price movement solely because of the long time period until expiration.

As frustrating as it is to see an unresponsive trend in a LEAPS position, it is an odd reality. In spite of the usual rules for interaction between intrinsic, extrinsic and time value, longer-term options are subject to these kinds of adjustments. So extrinsic value can act as an offset to changes in intrinsic value, or simply to hold down values of options due to the time itself. This does not mean that time value actually changes, but it does mean that the LEAPS will not act in the same, more predictable way that short-term options will act.

This can be an advantage, because the offset tendency works in both upward and downward movements. So if you are long on a LEAPS call contract and the stock declines, you are less likely to see a corresponding decline in the LEAPS call. Or if you own a LEAPS put and the underlying stock value rises, the offset can reduce the effect in the put value. Even with the offset experienced in extrinsic value, however, using LEAPS calls and puts in long positions can continue to make sense over the long term.

The same arguments favoring buying calls in anticipation of an upward-moving market apply just as well when you expect market values to fall. You can buy LEAPS puts when you have seen a big run-up in value and you anticipate a reversal. This strategy makes sense whether you own stock or not.

When you own shares and the market value has risen substantially, you face a dilemma. Do you take your profits now, while you can, and risk missing out on even more appreciation? Or do you wait, risking losses when prices fall? You may continue to think of the company as a sound long-term investment, so you don't want to sell; but you are worried about short-term corrections to market price. If you buy a LEAPS put in this situation, the downward price movement in the stock will be matched point for point by increasing value in the in-the-money LEAPS put. You also discount your basis by selling calls with rich time value premium, an alternative to profit taking that allows you to continue owning shares.

When you don't own shares and market value has run up, buying a put is a speculative move. You anticipate a correction; when prices fall, you will experience a corresponding increase in value of the LEAPS put. Without taking a short position or selling uncovered callsâboth high-risk strategiesâyou can profit if you are right when stock market prices fall, by owning the put. And because expiration is farther out, you have as much as three years to be proven right.

When you want to buy more shares and you believe the price is too high today, selling puts may work well for you. The premium you receive lowers your basis and risk, and as long as you consider the striking price a good price for shares, exercise would not be devastating. If share prices continue to rise, you keep the premium from selling the put. This strategy mitigates the dilemma for every stock investor: If you buy more shares today and prices then fall, you have a paper loss position. If you don't buy more shares and the stock's price rises, you miss the opportunity. Look at short puts as a possible solution to this dilemma.

Smart Investor Tip

Using LEAPS to time market swings or insure other positions is more practical than with short-term options. The longer time until expiration provides better value, enabling you to protect paper profits more economically.

The advantage of longer expiration overcomes the option buyer's ongoing struggle with time, at least to a degree. In long positions, you will pay more for time value but you have more time. In a volatile market, your chances of profiting with LEAPS calls and puts are greater because expiration is not immediate.

In addition to trading in LEAPS on individual stocks, you can also buy or sell index LEAPS. These are somewhat more complex because the relationship between striking price and index value is not the same as for individual stocks. In addition, index LEAPS may be set up in one of three ways. An American-style option can be exercised at any time prior to expiration. All short-term options and LEAPS in stocks are exercised as American-style options. However, some index options are European-style options, which means that exercise is allowed only during a shorter period of time immediately before expiration. A third variation is the capped-style option. This gives the owner the right to exercise, but only during a specific time period before expiration. If the option reaches its cap value before expiration, it is exercised automatically.

Even in the most uncertain of markets, the right strategy can be found to match the circumstances and your own risk tolerance. Options become most interesting when you move beyond the decision to buy or to sell and begin exploring the many strategies in the range of spreads, straddles, and combinations.

By Michael C. Thomsett

Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.